Warren Buffett explained it this way in the 2007 Berkshire Hathaway (BRKa) shareholder letter:"A truly great business must have an enduring 'moat' that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns."

An enduring 'moat' can come from things like an ongoing cost advantage or a strong brand that creates pricing power. Buffett later adds:

"Our criterion of 'enduring' causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism's 'creative destruction' is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."

That the 'moat' remains robust -- and, in fact, is made even stronger -- requires that management isn't too distracted by short-term goals in lieu of what Buffett calls 'widening the moat'. A management who chooses the former over the latter can do real and permanent damage.

"Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as 'widening the moat.'"

A business might currently have -- or appear to have -- a decent (or better) competitive advantages, but what those advantages will look like further down the road is questionable or difficult to understand. Well, big investment mistakes can get made when that's the case. If the moat that now exists will be meaningfully reduced, or worse, disappear altogether, then the estimate of intrinsic value has a great chance of being very wrong. When attractive core economics today become much less so later on, misjudgments regarding current valuation -- and how valuation will change over time -- are more likely. An unreliable moat means that, as time passes, future free cash flows become increasingly uncertain. The result possibly being poor investment results or even permanent capital loss.

Exciting growth rates may not prove to be worth much if the moat collapses sooner than expected.

So quality businesses are those with advantages that are obvious, sustainable, and can be strengthened by competent management over time. A management who knows how to enhance whatever advantages exist, smooth out the important imperfections, and ultimately make the business tougher to dislodge from what is already an enviable position, can create a lot of long-term value.

The very best businesses can comfortably withstand mediocre (or worse) business leadership from time to time even if some real, at the very least temporary but possibly permanent, economic damage is caused by their actions (and maybe inactions).

Yet, as always, shares of even the best business needs to bought at a large enough discount to value to protect the investor from what is necessarily an uncertain future.

How price compares to a conservative estimate of value is one way -- though this has its limits -- to manage the unknown and often unknowable future risks. Always buying at a comfortable discount -- and what will be comfortable is necessarily stock specific -- protects, up to a point, against what might go wrong. Most of the time it's just not possible for me to come up with a reliable estimate of per share valuation for a particular stock. Well, at least not within a narrow enough range. This could be due to my own limitations or the characteristics of the business itself.

Either way, the right course of action will always be to stay well clear of any investment alternative where per share value within a range isn't obvious. The good news is that the investor always has the option of moving onto something else that's more understandable. For most stocks, it is simple avoidance that will be the way to go. The possibility of permanent capital loss is best reduced by paying an appropriately discounted price, considering the specific risks, for well understood businesses where per share intrinsic value can be estimated with high levels of confidence.

Buying the highest quality businesses -- those that generally have the very widest moats -- feels safer and certainly can be. At least that's the case if the price is right. In the late 1990s -- as well as with the so-calledNifty Fifty of the early 1970s -- some very good businesses became riskier to buy simply because of the extremely high prices relative to per share intrinsic value. Many still produced good investment results over the very long run but, since none of us have the luxury of investing with a rear-view mirror, paying such high prices did not offer much protection against what might go wrong. Just because it worked out that time tells you nothing about what's in store in the coming decades.

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

Shares of a merely decent business -- one with a moat though it may not be particularly wide -- bought at a huge discount to intrinsic value can actually be safer than the best businesses selling at a substantial premium. Still, all else equal and with the long-term in mind, I'd generally rather buy the higher quality businesses at merely reasonable prices than the lesser businesses with seemingly much bigger discounts. It's a matter of balancing the risk of permanent loss with potential reward.

The more uncertain something is, the bigger the discount to value one should pay. The tough part is that it's impossible to quantify all the risks. Judgment calls have to be made without precise numbers to rely on.

In a recent memo, Howard Marks wrote that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

I mentioned above that price has its limits when it comes balancing risk and reward. At times, the worst case scenario is so unacceptable that avoiding an investment with otherwise lots of potential upside is the right course of action. In other words no price will be low enough.

Later in the same memo, Marks offered the example of not wanting to be a skydiver who's successful just 95% of the time. With this in mind I added the following in a prior post:

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

Otherwise, the price paid often dictates the risks that are taken. If a high quality business is selling at 50x earnings -- or maybe even 100x earnings -- it is possibly far riskier than a decent business with some real challenges and little or no growth selling at 5x normalized earnings. The decent business may lack a compelling 'story' but, then again, the 'story' is often just a distractionfrom what really matters when it comes to investment risk and reward.

Again, this works only up to a point because many moat-less businesses are to be avoided altogether -- because of the worst case downside -- no matter how cheap they seem to be.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Origin of Newton's 4th Law?

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - Warren Buffett

About The Site

This site is for generalized informational purposes only and the views found here should never be considered specific investment advice.

Visitors should always do their own homework and consult, as needed, with a personal financial adviser who understands their specific individual circumstances before taking action on any particular investing idea. What makes sense as an investment in one set of individual circumstances may not in another.

Opinions found on the blog are just that, opinions, could easily be wrong in all kinds of ways, and should never be considered advice that is specific in nature. Stocks and other investment vehicles are inherently filled with risks including the possibility, or even likelihood, of permanent loss of capital. Past performance, of course, should not be considered indicative of future results. Due diligence is necessary.

The content found here shall not be taken as a recommendation to buy or sell any security or to participate in any particular investment strategy. Again, that necessarily comes down to individual circumstances. So, in other words, there is no personal financial adviser here, just some opinions and views. These opinion and views are subject to change at any time and, since they are not individualized in any way, consultation with an investment professional and doing one's own rigorous research/analysis before making any investment decisions is essential.

All posts are simply presented as one view on investing and some related topics though never specific recommendations. An investor should always get help from an investment professional if they feel they need it and, most importantly, before mistakes are made. Ultimately, the actions of individual investors, whether they happen to be a visitor to this site or not, are their own responsibility (and, if applicable, so are the associated losses). While there will always be a very real risk of permanent capital loss in investing, those who know their own limits and ask for professional advice when they require it can improve their chances substantially. Investors should never buy or sell a security based upon what they've read on any blog.

Information on this site is believed to be accurate yet may include errors or omissions and is not guaranteed. The site is also never a solicitation or offer to buy or sell any securities.

Posts on this blog do not offer opinions on the future price action of specific stocks or the capital markets as a whole. Instead, the focus is sound investing principles but never predictions or recommendations. It's understanding productive assets and their likely intrinsic value; how they may or may not compound in intrinsic worth over a long time horizon. It's about investing with a comfortable margin of safety. It's NOT about speculating on price action. In the near-term, or even longer, the market price of an asset can do just about anything.

A temperamental market pretty much assures it.

Those with a long investing horizon, it's worth noting, actually benefit from lower stock prices in the near-term (though not many market participants seem willing to put this truism to effective use). Those who attempt to profit primarily via speculating on short-term price action likely won't find this way of thinking to be of much interest.

The bottom line: This site does not provide individual investment advice of any kind and the blog posts found here are never a recommendation to buy or sell anything. Visitors should start with the assumption that the ideas found here are not good ones and do their own homework (or get individualized help from an investment professional) before taking ANY action.

This site's emphasis? Put simply, it's on finding and buying -- with the long-term in mind -- good businesses at a plain discount to conservatively estimated value; it's on selling shares of those well-bought high quality business reluctantly. The view here is that selling makes sense only when core economics become permanently impaired, prospects have been misjudged, market price not just somewhat but, instead, meaningfully exceed per share intrinsic value, or opportunity costs are high. Buy/sell decisions aren't just an opportunity to increase returns; they're also an opportunity to make mistakes. It's easy to overemphasize the former and forget the latter. The focus here is on minimizing trading, frictional costs, and errors of all kinds; it's on staying comfortably within realistically assessed limits. First and foremost is the view that an investor should never make a specific investment based upon what someone else thinks. In other words, what makes sense to own is necessarily unique for each investor and it'd be unwise to not act accordingly. So, more generally, this site simply attempts to better understand some useful principles and ideas in context of investment. It's about, in a practical sense, what tends to work over the long haul as well as what, at times, gets the investor into trouble. It's not about grand theories in finance and economics. These too often distract from what matters or, worse yet, lead to costly misjudgments. As a result, they are mostly viewed with a healthy dose of skepticism here. Otherwise, the best thinking across disciplines should be learned well then put to good use in a way that's uniquely suitable.

About

Notable Quote

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles... ...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?" - Charlie Munger